I used to work for banks. Now I write about them, and about finance and economics generally. Although I originally trained as a musician and singer, I worked in banking for 17 years and did an MBA at Cass Business School in London, where I specialized in financial risk management. I’m the author of the Coppola Comment finance & economics blog, which is a regular feature on the Financial Times's Alphaville blog and has been quoted in The Economist, the Wall Street Journal, The New York Times and The Guardian. I am also Associate Editor at the online magazine Pieria and a frequent commentator on financial matters for the BBC. And I still sing, and teach. After all, there is more to life than finance.

Banco Espirito Santo: A Portuguese Disaster, Not A European Crisis

The ratings agencies Moody’s and S&P have sharply downgraded the long-term debt ratings of the troubled Portuguese bank Banco Espirito Santo (BES). Both ratings agencies cite as the principal reasons for the downgrade the financial problems of BES’s ultimate parent, the Espirito Santo Group (ESG), and the possibility that the ring fence supposedly separating BES from its parents might prove insubstantial. Here is Moody’s explanation:

The downgrade of BES’s standalone financial strength rating to E/ca from E+/b1 reflects the risks associated with the bank’s direct exposure to the Espirito Santo Group and the likelihood that it may become liable for any further obligations stemming from the group. These concerns are heightened by the lack of information on BES’s ring-fencing against these risks.

S&P cites management instability within BES itself as well as its exposure to ESG:

At the same time, negative reports on what increasingly appears a fragile, and possibly deteriorating, financial position of several entities within the Grupo Espirito Santo (GES), of which BES is a part, have intensified.

The ownership structure is a mess. BES is 25% owned by Espirito Santo FinancialGroup, which is 49% owned by Espirito Santo Irmaos SGPS SA, which in turn is fully owned by Rioforte Investments, which is fully owned by Espirito SantoInternational(ESI)…

The exposure between these levels is equally opaque, with the WSJ highlighting back in Decemberthat ESI was utilising different branches of its structure, including BES, to fund itself up to the tune of €6bn. Currently, BES has admitted it has the following exposure: €980m debt from Rioforte, but it also helped place €651m of debt issued by Rioforte and ESI to retail customers and €1.9bn to institutional clients.

This debt could essentially be worthless or massively written down. It’s not clear how open BES was about its conflicts of interest and if it misled buyers. There is a serious risk of lawsuits here. Citi has put potential total losses at €4.3bn, this could wipe out BES capital buffer and force it to raise a similar amount again.

This wouldn’t be merely a leaky ring-fence. It would be a gaping hole. BES is already poorly capitalized: despite raising additional capital after a bad result in the 2011 stress tests it is expected to do badly in the next round of stress tests scheduled for completion in October 2014. Bailing out its parent would be likely to mean bailing in its own creditors. Hence the downgrades.

Banco Espirito Santo, Lisbon. Photo credit: Wikipedia

But possibly not all of its creditors. For senior creditors, the downgrades are not as bad as they might have been. Moody’s maintained the ratings of the bank and its senior debt at a higher level than those of its immediate parent, Espirito Santo Financial Group (ESFG), which have been slashed to one notch above default. This is unusual: usually ratings of subsidiaries would be the same as those of their parents. But as Moody’s explains, BES is a bank – and banks can be recapitalized by their sovereigns (my emphasis):

The downgrade of BES’s senior debt and deposit ratings reflects (1) the downgrade of its standalone BCA to ca; and (2) Moody’s assessment of a high probability of support from the Portuguese government for the bank in case of need. The one notch differential between BES’s deposit and debt ratings, reflects our assessment of higher risk for senior debt holders versus the bank’s depositors.

S&P, too, says that its ratings are uplifted one notch in anticipation of sovereign support. So much for senior debt and depositor haircuts. The ratings agencies think that the Portuguese government will choose to recapitalize the bank directly rather than bail in senior creditors.

But the story for junior debt is quite different. Moody’s has downgraded subordinated debt and preferred stock to C – which is default. So Moody’s is not only certain that BES will need recapitalization, either because of parental debt obligations or because of its own weak capital position and risky balance sheet; it also expects that junior creditors will be bailed in. BES’s junior debt is now worthless.

This is as it should be. Junior debt holders should take the first hit after shareholders when a bank needs to be recapitalized. But the expectation of sovereign support for senior debt raises some very uncomfortable issues.

Failing to bail in unsecured senior creditors would contravene the European Bank Resolution Directive, though admittedly this has not yet come into force. And it is not consistent with the treatment of banks in Cyprus, where a highly-indebted sovereign forced losses on to senior creditors rather than take on even more debt. Portugal’s sovereign debt burden currently stands at 129% of gdp and it has only just exited from its bailout program. Adding to the sovereign’s debt burden to recapitalize BES while allowing senior creditors to walk away seems insane.

But there is an additional problem. BES’s principal shareholder is a retail conglomerate. And the strange financing arrangements noted by Ruparel mean that the retail conglomerate may be able to drain the bank’s capital to meet its own obligations. If the Portuguese sovereign then steps in to recapitalize the bank, it will have indirectly bailed out the retail conglomerate.

Sovereign recapitalization of banks can perhaps be justified on the grounds that disorderly failure would have disastrous economic effects, although countries can and do wind up insolvent banks rather than recapitalizing them. But there can be no justification whatsoever for bailing out a sprawling retail conglomerate with a corporate structure of extraordinary complexity and opacity. Highly complex and opaque corporate structures exist for one purpose only, and that is to disguise the true nature of the financial shenanigans going on. I’d guess that ESG management deliberately involved the bank in the financing of ESG retail customers because they knew that if it all went horribly wrong the sovereign would be on the hook. Portuguese regulators should have been taking far more of an interest in the organisation of ESG.

This is why the troubles of BES call into question the creditworthiness of the Portuguese sovereign. The “doom loop” between banks and sovereigns is as strong and toxic as ever. Unless the Portuguese sovereign takes a stronger stand on senior creditor bail-in than anticipated by the ratings agencies, the consequences for the Portuguese fiscal position – and for its economic recovery, since a deterioration in its fiscal position would mean more austerity – don’t look good.

But that doesn’t justify the panicky reaction of markets so far. There is no reason for investors to assume that other sovereigns would necessarily be affected by the Espirito Santo mess, or that the European banking system is necessarily at risk (although some banks will suffer losses). This is a Portuguese domestic disaster. How it is handled matters for Portugal, and for the principles of justice. But it doesn’t mean another Eurozone crisis.

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“And the strange financing arrangements noted by Ruparel mean that the retail conglomerate may be able to drain the bank’s capital to meet its own obligations.”

Perhaps this was the case while the bank was run by the ES family and wasn’t under particular regulatory scrutiny. But now that BES is independently run, ES holdings are down to 20%, and the bank itself squarely in the public spotlight, surely ESFG won’t have any recourse to the bank’s capital whatsoever, no?

Yes, the changes made over the weekend will make a big difference. However, there is still the Angolan exposure, and it is also not clear what the bank’s liability for loans made to ESG’s customers will be.